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Portfolio Evaluation

This web page is complicated, but it's important to read as far as you can. If you get too bogged down in it, skip to the last two sections for some encouragement.

Ok, here we go.

Many people buy and sell investments based on articles they read, advice from a professional, and personal theories. They try to time their buys and sells. They have anecdotes of gains that encourage them, and of losses that they try to forget. But when you ask for their asset allocation between stocks and bonds, they need to go away and tally it up - despite that it determines 80% of their return. And, they have no way to assess whether their investing work adds or subtracts value beyond what they would undoubtedly receive from buying and holding a single, balanced, index mutual fund.

To learn how to compare your actual results with a meaningful benchmark, read on.

Benchmarks

The first step is to identify a benchmark to measure your portfolio against. To do this, first analyze your portfolio and determine your actual asset allocation (the percentage of stocks and the percentage of bonds). Then you can choose a benchmark of globally diversified stocks and bonds to use as a benchmark. You could construct a benchmark from combinations of various indexes, but that's a lot of work. It's more accurate and much easier to identify a certain index mutual fund that best fits your investment asset allocation. For benchmarks, I like the ones below. The first one is a great benchmark for your whole portfolio (all accounts, taxable and tax-advantaged). The next four are if you want separate benchmarks for portfolio sub-categories.

Overall portfolio: Choose the Vanguard LifeStrategy Fund that best matches your actual or target asset allocation (or splice together two of the LifeStrategy Funds for more precision, covered later). Each of the four LifeStrategy funds is constructed from the following four funds: VASIX (20/80), VSCGX (40/60), VSMGX (60/40), and VASGX (80/20), where the first number is the percentage of stocks and the second is the percentage of bonds in the fund. Each of these funds is automatically rebalanced.

International bond subset: Vanguard Total International Bond Index Fund (VTABX)

For a benchmark, you want to determine the Compound Annual Growth Rate (CAGR) of the benchmark mutual fund, including reinvested distributions, minus fund expenses. Let's assume you want a benchmark for a 40/60% stock/bond portfolio, which is the VSCGX fund. Just put its ticker symbol into any browser to get Vanguard's top page for this fund. Then click on the "Price & Performance" tab to see that investment's Average Annual Return for 1, 3, 5, and 10-years.

The "Average annual returns" (circled in blue) are not explicitly labeled "CAGR with reinvested distributions," but that's what they are (I'll explain later). Since these do not include fund expenses, check the "Overview" tab to find that fund's expenses and subtract it from the "Average annual return." If it's the beginning of a year, that's your Benchmark. For example, the 3-year Average Annual Return is 5.21%/year, minus the 0.15%/year expense gives you a benchmark of 5.06%/year.

How do you know these are CAGRs? Return to the "Price & Performance" tab. Notice that that line of "Average annual returns" shows up on this page, too. Now click on the link "See cumulative, yearly, and quarterly historical returns" (circled in blue).

That will take you to the screenshot of "Historical returns" (below). Look in the top area to see the "Cumulative Total Returns." For example, the 3-year number for this fund 16.46%. That's not the return for one year, it's the return for three years combined, including reinvested distributions but not factoring in expenses.

To turn a 3-year cumulative return into an annual compounded return, take the cube root of the 3-year number, 16.46%, and you'll find that it computes to 5.21%/year.* That's the same compound return we found earlier, confirming that the numbers labeled "Average Annual Return" are, indeed, CAGRs.

Lower down in this screenshot you can also see part of the "Annual Investment Return" chart, which separates capital and income (dividend) returns. After a little math, you'll find that the numbers completely agree with the previous ones. And, still further down on this webpage, you will find quarterly results, which also completely agree. You can use these annual and quarterly numbers to construct a benchmark for virtually any time period you like.

What if your asset allocation target isn't exactly one of the Vanguard LifeStrategy Funds? For instance, suppose you want to build a benchmark for a 57% stocks, 43% bonds portfolio. It's pretty easy to do, but it would make this web page too long. So I put it on this web page: Benchmark Details.

Measuring Actual Portfolio Returns

An actual portfolio is fundamentally different from a benchmark in that after the initial investment, you later add more money to the portfolio, and withdraw money from it. The prices and times of these buy/sell transactions significantly impact the underlying portfolio returns. Financial people use Internal Rate of Return (IRR) to describe the underlying portfolio returns. Then you can compare your IRR with the CAGR (minus expenses) of the benchmarks. To better understand IRR, check the Glossary and look up Internal Rate of Return.

If all your investments are in one place, that company's website should calculate the IRR for any combination of retirement accounts, taxable accounts, or most any other investment subsets you need. For instance, at Vanguard'st IRR includes expenses, fees, and any sales charges. So this IRR is the number to compare with the benchmark. If you have investments elsewhere, you can manually insert these into your Vanguard portal. Unfortunately, that is not enough detail for Vanguard to include these in your IRR calculation.

When your investments extend across many investment companies, finding the IRR is more difficult. When I use Quicken (an aggregator) to calculate the IRR of any subset of my Vanguard accounts, the results agree remarkably well (The last time I did this they differed by only 0.2%). Quicken's IRR calculation inherently includes expenses, fees, and sales charges.

A possible strategy for computing an IRR for dispersed accounts is to use the IRR calculation tool of each investment company (if they have one) and then manually aggregate them into an IRR of your total portfolio. I haven't tried this (because most of my investments are in Vanguard), but it should work for investments held in companies that offer a comparable IRR computing tool.

The increased difficulty of computing IRR across investment companies is a reason to consolidate as many of your investments in one place as possible. The benefit of knowing how actual returns compare with a meaningful benchmark is worth more than the small differences between the returns of similar investments from various companies.

Is your investment strategy paying off?

Now you have the compounded growth for your benchmark, with expenses subtracted out. And you have the IRR of your actual portfolio, either from your investment company, manual aggregation from various investment companies, or from Quicken. Hopefully, your actual IRR is larger than the Benchmark.

Let's suppose you're managing $100k and find that your IRR beats the benchmark by 1.5%/year. So the value added (a sort of alpha) for managing your portfolio that year is 1.5% of $100k, which is $1,500. If you are satisfied receiving this "compensation" for your work, keep on doing what you are doing. Otherwise, stop actively managing and just buy the benchmark fund.

Of course, managing a $1M portfolio requires only slightly more work. The same 1.5% difference now comes to $15,000.

For more on this general topic of measuring the results of your portfolio management, check out Investopedia's post: Measure Your Portfolio's Performance, and especially notice the Jensen Ratio (sometimes referred to as Jensen's Alpha).

But I can't or won't do all this work?

I know the level of portfolio analysis in this web page is more than many investors can, or want, to do. But without it, you simply can't measure if all your work of tilting, diversifying, and buying/selling is making money or losing money.

I'm a do-it-yourself investor. If you've read much of this website, you know that I use an asset allocation of globally diversified, low-cost mutual funds (mostly index) that fits my wife and my risk tolerance. The portfolio has 12-15 mutual funds (right, I don't even use ETFs). We rebalance periodically. Every year or two, I do the math and discover that our investment strategy beat the benchmarks by 1-2.5%/year. As we move further into retirement, I intend to simplify the strategy by incrementally reducing the number of funds to the right VanguardLife Strategy Fund for us, or maybe a splicing of two. Indeed, we started this glide path in 2015. Eventually, our investments will go on auto-pilot, and we'll just earn the benchmark - which is quite fine.

So here's my advice: If you are unable or unwilling to do the work of comparing your actual results with a benchmark, determine what asset allocation fits your risk tolerance and implement it with a simple set of 1 or 2 very low-fee funds. You can find good mutual funds that automatically rebalance - for example, the four Vanguard LifeStrategy Funds do this, as do all target-date funds.Despite what professionals say and write, it's hard to beat the single auto-rebalancing balanced mutual fund. If you buy that fund, you are certain to earn the market without doing any of the analysis described on this web page. And earning the market is pretty good. You can put the same mutual fund in your taxable and in your retirement accounts. Sure, you can save some taxes by where you locate funds, but at some point, many of us may reach an age when we can't do this level of management. For more on this, just follow the links in this paragraph and ignore the rest of this web page.

If you need help beyond what is in this and my other Personal Finance web pages, find a good Certified Financial Planner. Even if you don't need more help, at least, consider a Certified Financial Planner.

Certified Financial Planner

A CFP's fees and commissions make it hard to get investment returns above the benchmark, but using a CFP is better than trying to actively manage a stock/bond portfolio "blind." And a CFP contributes far more than just providing investing advice/implementation. For example, a CFP also...

Helps you navigate the world of insurance (health care coverage, life, long-term care, and annuities).

Helps with cemetery and funeral plans.

Provides guidance on tax-smart charitable giving.

Helps configure gifts to family members while you are still alive

... and many other things.

Think of your CFP like you think of your primary care physician. Both help directly with some items and connect you with specialists for the rest. You pay both your primary care physician and the specialists. Similarly, your CFP needs to get paid. Unlike your primary care physician, most CFPs are willing to get paid, at least partially, through commissions on some of the products and services that he/she directly provides. So while CFP commissions lower your investment returns, remember that you are paying your CFP for his/her broad services from a modest percentage of your investment gains. And, don't be surprised when your CFP sends you to specialists who you'll have to pay separately. Sometimes you'll pay them a flat fee (such as an estate attorney) and sometimes you'll pay them over time, through commissions (such as an annuity or insurance specialist).

Where do you find a CFP? Whether you are a Christian or not, I suggest you look for one who is a member of Kingdom Advisors. You can check out their website to find one near you. I am not a Qualified Kingdom Advisor, but I meet with a group of them in their monthly meeting where we learn and talk about how to serve Christ as we help all kinds of clients manage their money. Kingdom Advisors almost always work for a company, their own or one that provides their investing or insurance products, or both. But Kingdom Advisors are separately glued together by this additional organization.

All the best,

Tim

*A math reminder: To calculate the compound growth rate of a cumulative return over n time periods, take the nth root of the cumulative number. In the general form, it looks like this: compound growth rate = (cumulative growth)1/n. For instance, to find the 3-year compound return that leads to a 16.46% 3-year, cumulative gain, you must solve 1.16461/3 . You can solve this with a calculator, or just type this into the address bar of any browser: "1.1646^0.333=", and hit enter. It will compute the answer as 1.0521, meaning that it is a compound return of 5.21%/year.

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